While swaps, derivatives, and other exotic financial instruments can serve as effective risk management tools, they can be abused with ease to act as a kind of financial nitroglycerin, creating great swaths of destruction throughout global and domestic economies. This brief survey examines the derivatives trading market, highlighting the critical role of derivatives in the 2008 financial industry collapse. The following pages contain brief, but vivid, descriptions of some of the more common financial instrument variants, which include credit default swaps (CDS) and collateralized debt obligations (CDO). A succinct discussion of their positive hedging capabilities is juxtaposed with the nightmare financial scenarios created by their misuse and misapplication. A brief digression examines how the United States transitioned from a period of many decades of stable financial industry activity to the current ongoing economic stagnation, a direct consequence of the remorseless 2008 Wall Street implosion. Finally, a glimpse is proffered of the Dodd-Frank Act, a quixotic regulatory reform effort, which purports to instill much needed discipline and transparency onto the Wild West, guns-a-blazin’, recklessness heretofore characterizing the derivatives trading industry.
Financial Nitroglycerin or Risk Management?
Swaps, derivatives, and other exotic financial instruments, when used appropriately, comprise effective risk management mechanisms, reducing inherent financial industry risk for the individual, the firm, and the overall economy. However, in the real non-hypothetical world where money equals status and power, both personal and political, these otherwise benign investment tools, a kind of financial nitroglycerin, are more likely to be used in reckless speculative attempts to create short term profit, while ignoring the associated high risk and dangerously destabilizing impact upon the overall global economic system. Griffith (2012) insists that “both hedging and speculation are vital features of a working financial system” (p. 1158), where hedging is a mechanism used to “eliminate unwanted risk” and speculation expedites “price discovery and, therefore, market efficiency” (p. 1158). The potential aftershock of a weakened financial system, perhaps, is not something to fixate upon.
So, how are these “otherwise benign investment tools” transformed into financial nitroglycerin? According to Griffith (2012), “counterparty risk [is] the fundamental risk associated with derivatives transactions” (p. 1157). Counterparty risk is the likelihood that one or another party to the agreement will default on contracted obligations (due to business insolvency or related), thereby leaving the other counterparties still holding the risk that supposedly had been hedged away (p. 1161). The default of one counterparty can lead to the default of the other counterparty, who might also be counterparty to yet another derivatives contract, precipitating a cascading series of defaults throughout the entire financial system. Griffith refers to this phenomenon as “systemic risk”: “the linkages and interdependencies between participants in the financial market, such that a significant loss initially touching only a small number of participants can spread and threaten to engulf the entire system” (p. 1163). Like the spread of STDs through a population of sexually active adults, systemic risk is a “negative externality of derivatives transactions” (p. 1164), based on ever present and non-hedge-able counterparty risk. Ultimately, systemic risk can be viewed as the hidden cost of derivatives-based liquidity and lower costs of capital (p. 1167).
Other forms of derivative transaction risk include model risk and rating agency risk (Gibson, 2007, p. 37). While noting that a “model is only an approximation of reality” (p. 38), model risk refers to the difficulty of creating accurate models and the challenge of eliminating flaws from the complex models used for valuation and hedging (p. 37). Without assurance of accuracy in the forecasts and projections produced by models in the high-risk high-stakes game of derivatives trading, counterparties to these types of investments might seriously misjudge the associated dangers and make big mistakes that cause serious financial injury to themselves or their clients. Rating agency risk implies a lack of credibility in the assessment by a particular agency (e.g., Standard & Poor’s, Fitch, and Moody’s) of the credit risk of a particular investment vehicle. In effect, despite stamping a similar rating (e.g., AAA) on both a derivative and a typical corporate bond, the rated derivative is always going to be riskier than the bond. This is an implicit acknowledgement that “ratings of [derivative] transactions are fundamentally different than ratings of corporate debt” (p. 38). The execution of a derivatives transaction based solely on its agency produced rating can be a very perilous exercise indeed.
To put the dangers of misuse of financial instruments into a real-world context, consider that local and state governments raise money for all manner of projects (e.g., roads, schools, etc) by issuing municipal bonds, a well-known safe and secure (and boring) investment opportunity for a wide array of investors, with clearly stated returns and maturities. Sometime in the 1990s the allure of the derivatives market began to attract the attention of the political class (Raghavan, 2011, p. 195), those stalwart souls who take it upon themselves to manage the administration of civil society and its humdrum requirements (e.g., trash collecting, licensing and permits, etc) and citizen service (via the myriad of local agencies serving one constituency’s needs or another). Specifically, “municipal bond issuers started using derivatives in an effort to minimize interest costs” (p. 195), an approach resulting in significant financial harm to “many small towns and school districts” (p. 195). Problems occurred for three main reasons: (1) local political leaders, due to general ignorance of the derivatives market, had no idea about the dangers they were creating for the local jurisdictions; (2) the “intentional obfuscation” by investment bankers regarding the “complexities of the deals” (p. 195); and (3) the inability of local officials to demand detailed straightforward explanations of the inherent booby-trap-like complexities of the derivatives contracts (p.195).
Some examples should make clear the magnitude of the impact of this dangerous dalliance with derivatives. Jurisdictions in Chicago, Denver, Philadelphia, Los Angeles, Oakland, and the states of Massachusetts, New Jersey, New York, and Oregon are all “losing money on poorly designed interest rate swaps” (Raghavan, p. 197). In 2007 and 2008, Jefferson County, Alabama, was dealt a crushing financial blow due to “a lethal combination of incompetent borrowers, poor internal control and governance procedures, and complex financial instruments [including] poorly designed swaps,” pushing the county to the “brink of the largest municipal bankruptcy ever” (p. 197). Ultimately, losses to local coffers are borne by local taxpayers, imposing a forced austerity and economic hardship on local jurisdictions trying to dig out of the (unnecessary) financial collapse. Sadly, the folks living in Jefferson County are just one set of direct victims of this financial instrument chicanery. Many of these hoodwinked jurisdictions are trying to buy their way out of these horrible derivatives deals, especially difficult to accomplish during the persistent sluggish macro-economic landscape, and “are faced with paying high fees at a time of collecting lower tax revenues” (p. 198), which only adds to the local fiscal strain.
The Big Daddy of financial disasters with roots in malfeasant derivatives usage, and eclipsed only by the Great Depression of the 1930s, was the financial industry meltdown of 2007 and 2008, which produced the lingering Great Recession and put the United States economy into ongoing stagnation. Derivatives trading fanned the flames of the growing weakness in the home mortgage industry until the crisis exploded throughout the financial industry, dealing a staggering blow to the global economy (Griffith, p. 1166).
What Are Financial Instruments?
Defined as a “tradable asset of any kind; either cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash or another financial instrument” (Financial Instrument, n.d.), a financial instrument, for the purposes of this report, is one of many flavors from the family of derivatives. A mechanism often used for the responsible objective of hedging but also employed in wildly speculative schemes, the derivative is a “financial contract whose value is derived from a security,” which might include a stock, bond, commodity, market index, or similar (Quirk, 2010, p. 37). Essentially, a derivative is a bet placed on the price movement of some other financial instrument, or as Griffith (2012) explains, it is “nothing more than a contractual means by which parties allocate the risk of a fluctuation in price of an underlying reference value” (p. 1158). A future exchange of payments between the counterparties is the specific means by which risk is reallocated, and the underlying reference value could be almost anything including an interest or exchange rate, a mortgage-backed security (MBS), or the weather (p. 1158).
Often, derivatives trading involves not the actual commodity or stock or bond or anything with real tradable value, but instead a “portion (or all) of one or the other positions (long or short) on the underlying risk” (Griffith, 2012, p. 1159). In effect, derivatives “trading” is about placing bets on the risk associated with any of myriad financial instruments. The dark mysterious world of derivatives trading takes place as a series of “privately negotiated [agreements] between buyers and sellers” in what is called the “over-the-counter (OTC) derivatives market” (p. 1159), which some folks might refer to as the OTB, or off-track-betting, market.
One type of derivative is the collateralized debt obligation (CDO) and its associated derivative, the synthetic collateralized debt obligation, or synthetic CDO (Quirk, p. 37). For example, as home buyers procure mortgage loans, the lending institutions sell the individual mortgages upstream to a Wall Street investment bank where they are bundled together into a new security, a mortgaged-backed bond (p. 37). Many such mortgage-backed bonds are bundled together into yet another security, the collateralized debt obligation, which is then sold to investors (p. 37). This process, known as securitization, is a method of “collecting cash-flow rights in a large pool and then selling interests in the pool in smaller chunks to investors” (Griffith, 2012, p. 1165). The value of these investments is the fixed stream of cash payments from the original home owners who make monthly mortgage payments. Of course, any mortgage loan defaults would decrease the value of these investments. As an aside, it seems rather amazing that this loan bundling process is even possible or legal.
The synthetic CDO is a similar security, except there are no mortgages directly involved, and the “investment” is really a wager that housing prices will rise or fall, depending on whether the gambler/investor takes the “long” side (hoping for a rise in prices) or “short” side (hoping for a drop in prices) of the bet (Quirk, p. 37). In this scenario, another financial instrument, the credit default swap (CDS), a type of financial investment insurance, is the mechanism through which the “short” player pays interest to the “long” player, while the “long” player is obligated to pay the principal of the CDO if it defaults (p. 37). The credit default swap is defined as a “derivative where two counterparties exchange streams of cash flows with each other, [with] payment calculated by reference to a principal base (notional amount)” (Greenberger, 2011, p. 132). The investment bank, essentially playing the role of bookie, handles all the particulars for establishing the contract between the counterparties. The swap, in effect, allows one entity to “buy protection” from another entity “selling protection,” whereby the protection buyer makes a series of payments to the protection seller, similar to insurance premiums, “in exchange for the seller’s commitment to offset any losses suffered by the protection buyer in the event of a default or other credit event of another party, the ‘reference entity’” (Griffith, p. 1160).
The “simple” example described above betrays the most serious problem associated with the derivatives market: non-transparent complexity, especially as many financial instruments and related investments are interlinked through a widening array of seemingly unconnected counterparties, where no one really knows who is at risk if problems (e.g., defaults) occur anywhere along the investment chain. It is like a game of no-limit poker, where the bets keep increasing to the point where they dwarf the size of the global economy, thus putting everyone at risk in their Las Vegas-on-steroids investment approach (Quirk, p. 37). The introduction of counterparty credit risk to the mysterious world of derivatives trading increases the possibility of calamity considerably. Griffith (2012) notes that “if a protection seller defaults, the buyer remains exposed to the risk of default of the underlying reference entity” (p. 1162), and the whole house-of-cards can come tumbling down in dramatic fashion.
How Is It Supposed To Work?
“Risk diversification and risk management are among the central pillars of modern finance and investment” (Johnson & Kwak, 2009, p. 37). Managing risk is the seemingly benign justification for all the various behind-the-scenes, “black box,” and non-transparent financial industry trading and transacting machinations, which at their most reckless and vainglorious have cratered the U.S. and global economies. When used appropriately, however, derivatives trading may serve as an effective risk management tool, especially for “commercial banks, investment banks, and investors” (Gibson, 2007, p. 27). Commercial banks use derivatives “to shed risk in several areas of their credit portfolio” (p. 27), including loans to large and small corporate enterprises and emerging market entities, while covering risk from various types of counterparty exposure (p. 29). Investment banks choose derivatives as a risk management device for their wide-ranging securities underwriting services (p. 28). From “buy-and-hold” investors to “active traders,” investors of all stripes and inclinations find derivatives to be “more flexible and less expensive than transacting in cash securities” (p. 30). An important aspect of derivatives is their ability to be customized, tailored to specific components of risk such as “spread risk, default risk, recovery risk, or correlation risk” (p. 31). Derivatives provide the hedging benefits associated with owning or selling debt (e.g., bonds) without actually acquiring the bonds themselves (p. 32). So, in a sane non-greed-driven world, it is possible that the use of derivatives and other exotic financial instruments could be considered a highly effective component of a successful risk management program.
How Did We Get Into This Mess?
Prior to the 1990s, “investment banks were organized as partnerships” (Quirk, 2010, p.36), an organizational structure that reinforced and rewarded prudent financial behavior because the partners’ own money was at risk in bank operations and, as a result, they were less likely to proceed recklessly in a frantic attempt at profiteering (p. 36). The partners at the head of these firms were already wealthy and they were reasonably content to build gradually on that wealth, ensuring a secure respectable livelihood and high standard of living for themselves and their families. All of this sublime serenity went out the window when “almost all the partnerships reorganized into corporations” (p. 36), and the formerly reputable respectable investment banks transformed into “liability casinos operated by croupiers unbridled by long-term financial responsibilities” (p. 36). The new credo became a clarion call to “maximize day-to-day profits” (p. 36). As profit-seeking corporations, with financial risk spread among countless shareholders instead of a handful of private partners, investment banks now became free to focus fervently on short term gains, free to gamble with other people’s money, free unwittingly to destabilize the macro economy, free to be unrepentantly evil.
Another sledgehammer blow to the regulatory fortress protecting the economy, the financial system, and the taxpayer from misguided behind-the-scenes financial instrument shenanigans was the enactment of the Commodity Futures Modernization Act of 2000 (CFMA), which effectively liberated over-the-counter derivatives transactions from any shred of federal or state oversight and regulation (Greenberger, p. 142). Among other noteworthy tenets of the Act, the Securities Exchange Commission (SEC) was prevented from providing OTC oversight, and the OTC derivatives market was no longer beholden to major aspects of the Commodity Exchange Act of 1936 (a vital piece of Depression-era legislation that held the financial industry in check for many decades). Free from “capital adequacy requirements; reporting and disclosure; regulation of intermediaries; self regulation; any bars on fraud, manipulation and excessive speculation; and requirements for clearing” (p. 142), the multi-trillion dollar derivatives market was ripe for exploitation and exuberantly irresponsible speculation, effectively transforming it into a legalized gambling casino.
At the time of the 2008 economic collapse, the mostly unregulated OTC derivatives market, valued at nearly $600 trillion, with credit default swaps accounting for nearly $60 trillion of that amount, represented the apex of financial alchemy, the transformation of high-risk subprime mortgages into AAA-rated collateralized debt obligations (Greenberger, p. 145). Mathematical probability algorithms enabled financiers to camouflage high levels of pervasive systemic risk, thus destabilizing overall economic health for the purpose of pursuing short term profiteering schemes. The game was based upon the bundling of home loan mortgages and the transformation of these bundles into mortgage-backed securities (MBS), the financial nitroglycerin at the heart of the 2008 financial industry catastrophe. The MBS spawned a dizzying array of derivatives “insured” by an even wider array of credit default swaps, all of which was premised upon the “faulty assumption that housing prices would never go down” (p. 146). As such, CDSs were considered to be without risk, dependent only upon the sustained health of the U.S. domestic housing market, with no expectation that issuers would ever be called to make the large payments required in case of losses to the underlying mortgage-based CDOs (p. 146).
Of course, inevitably, when housing prices began to drop, prior to the emergence of the 2007 crisis, CDS issuers were caught without adequate funds to cover the losses. Due to the prevailing systemic/counterparty risk, the incestuous interlocking of world-wide derivatives-based transactions, the entire global financial system began to seize, as no domestic entity (besides the U.S. federal government) had any funds to cover any of the contracted commitments (Greenberger, p. 146). Every stakeholder, private and government, was shocked (shocked!) by the size and scope of the problem. Apparently they were all shocked (shocked!) to discover that a non-transparent non-regulated sector of the financial industry featured such potentially economy-destroying secret practices and processes. Kirkwood (2014) has opined that “derivatives might not be the outright cause of the global financial crisis, [but] they played a major role.” Indeed they did!
Since the crash of 2008, efforts have been made to put a damper on derivatives trading madness. Specifically, regulators have been seeking ways to bring the highly unregulated over-the-counter derivatives market under some measure of official scrutiny (Johnson, 2011). The Dodd-Frank Wall Street Reform and Consumer Protection Act, the legislative answer to the financial industry meltdown, has endured endless rounds of tweaking and watering-down, as the forces from Wall Street battle the various government agencies charged with overhauling the rules governing high finance. As the smoke clears, new “regulatory burdens on swaps [include] increased clearing times and margin requirements for standardized swaps” (Thomas, 2013), as the “huge swap regime [is] nudged onto regulated and competitive central trading venues and into credit-enhancing clearinghouses” (Johnson, 2011).
Depending on the particulars of the final Dodd-Frank legislative package, CFOs across the land expect a tighter leash when it comes to the formerly opaque, yet unbridled, realm of OTC trading. Expected are new and/or increased “margin requirements on new derivatives transactions in the future” (Brown, 2012, p. 28); restrictions on the type of eligible margin collateral to “cash, … U.S. Treasuries, … and some agency bonds” (p. 28); major increases in “capital requirements to protect against potential losses and to ensure [banks’] safety and soundness” (p. 28); subjecting firms conducting “inter-affiliate transactions” (i.e., those derivatives trades taking place among affiliates of firms) to the same regulatory requirements as those firms engaging directly in such transactions (p. 28); and requiring any firm designated by the new financial industry rules as a “financial entity [to be] subject to the clearing and trading requirements” (p.29). Already there is much grumbling by corporate entities about the burden implied by these new regulations (p. 27). Yes!
While swaps, derivatives, and other exotic financial instruments can serve as effective risk management tools, they can be abused with ease to act as a kind of financial nitroglycerin, creating great swaths of destruction throughout global and domestic economies. This brief survey examines the derivatives trading market, highlighting the critical role of derivatives in the 2008 financial industry collapse and in other lesser municipal fiscal reversals. Both the benign and the cancerous aspects of derivative transactions are on display throughout the report, with a focus on the dangers inherent in any unregulated financial market, juxtaposed with recent efforts to place necessary constraints on derivatives. Presumably, going forward, prudent temperaments will trump the zealots who chase profit at any cost, destroying lives with their reckless financial scheming. Otherwise, we as a citizenry are doomed to suffer repeats of the 2008 economic calamity, a catastrophe of such scale that many millions of Americans watched helplessly as their fragile claim on the promise of the American Dream evaporated into joblessness, bankruptcy, and foreclosure.
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